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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO 2015 NUMBER 349 Chicago Fed Letter Wage growth, inflation, and the labor share by Lisa Barrow, senior economist and research advisor, and R. Jason Faberman, senior economist The recent pattern of nominal wage growth has been a puzzle to economists, researchers, and policymakers because it lies well below the trend wage growth predicted by inflation and productivity growth. We show that the difference can be reconciled by accounting for the labor share of output, which has been on a declining trend for the past 15 years. Wage growth remains low, despite gen- eral improvements in the labor market since the most recent recession. From 2010:Q4 through 2015:Q1, nominal wage growth in the nonfarm business sector 1. Quarterly nominal wage growth, actual and trend averaged 2.1% per year, y/y percent change up only slightly from average annual growth 12.0 of 1.9% from 2007:Q4 10.0 through 2010:Q4. 8.0 Between 2010:Q4 and 2015:Q1, trend pro6.0 ductivity averaged 1.4% 4.0 per year and the Fed inflation target was 2.0 2%, leading many to wonder why nominal 0.0 wage growth was not 1968 ’72 ’76 ’80 ’84 ’88 ’92 ’96 2000 ’04 ’08 ’12 closer to 3.4% over Nominal wage growth (actual) this period. Even if Trend nominal wage growth one took into account Trend productivity growth + inflation the low rate of actual inflation over this peNote: The shaded areas represent recessions as classified by the National Bureau of Economic Research. riod, it would suggest Sources: Authors’ calculations using nonfarm business compensation and output per hour from the U.S. Bureau of Labor Statistics, core PCE (personal consumption that nominal wage expenditures) inflation from the U.S. Bureau of Economic Analysis, ten-year expected growth should be inflation from the Survey of Professional Forecasters, and labor share estimates from the Board of Governors of the Federal Reserve System. closer to 2.9%. If wage growth is a signal of future inflation, then understanding the factors contributing to the shortfall in wage growth is important for informing monetary policy. In this Chicago Fed Letter, we use the definition of the labor share of output to decompose the wage growth gap— the difference between actual nominal wage growth and trend wage growth— into its component parts.1 The labor share (compensation as a fraction of business revenue) had been relatively constant for many years, suggesting that policymakers could essentially ignore it when thinking about the wage– inflation relationship. Starting in 2001, however, labor share began a fairly steady decline, meaning that it could no longer be ignored when one estimates trend wage growth. Our decomposition shows that accounting for the decline in trend labor share can explain nearly the entire gap between observed nominal wage growth and the growth predicted by trend productivity growth and inflation. Framework for thinking about wage growth A firm’s labor share represents the total compensation paid to workers as a fraction of total revenue. Total worker compensation is average hourly earnings (which include wages, salaries, and benefits in the data, although we will refer to it as the “wage” for simplicity) multiplied by total hours worked by all employees. Total revenue (or value added) is the average price received from sales multiplied by total output. Therefore, one can express the labor share as follows: wage × hours labor share = . price × output gaps is positive, it contributes to driving nominal wage growth above its trend; and if one of the component gaps is negative, it contributes to driving nominal wage growth below its trend. 2. Labor share, actual and trend share of labor output 0.70 0.66 0.62 Because the measures come from four different data sources, actual nominal wage growth need not equal the sum of its component growth rates. Therefore, the nominal wage growth gap will be the sum of the labor share growth gap, the labor productivity growth gap, and the inflation gap plus a measurement “residual.”3 We apply these defiA look at the data nitions and relationIn figure 1, we present quarterly nomiships to the data using 0.54 nal wage growth from 1968:Q1 through nonfarm business 2015:Q1, along with the sum of trend compensation to 0.50 productivity growth plus trend inflation. 1968 ’72 ’76 ’80 ’84 ’88 ’92 ’96 2000 ’04 ’08 ’12 measure wage growth, This sum is what policymakers have Actual labor share real nonfarm business typically used as a measure of trend output per hour to Trend labor share nominal wage growth, since trend labor measure labor proNote: The shaded areas represent recessions as classified by the National Bureau of share has historically shown little change. Economic Research. ductivity growth, and During the 1970s, this estimate of trend Source: Board of Governors of the Federal Reserve System. the price index of nominal wage growth was below actual personal consumpnominal wage growth, while during the tion expenditures, excluding food and The equation holds for both individual 1980s and early 1990s it was above actual energy (i.e., “core” PCE) to measure firms and for the aggregate economy. nominal wage growth. At the onset of inflation. Our measures of labor share, One can rearrange the terms in this the Great Recession, observed nominal both actual and trend, come from equation to show that the wage is equal wage growth fell much more than the the Board of Governors of the Federal to the product of the labor share, labor traditional measure of trend nominal Reserve System. The Board of Governors productivity (i.e., output per hour), and wage growth. estimates trend labor share by applying the output price, output a filter to measures of real compensaFigure 1 also plots trend nominal wage wage = labor share × × price. tion per hour and labor productivity in growth based on our decomposition hour described earlier, which accounts for As a result, one can express wage growth a way that is consistent with our labor share equation above. We use a measure changes in labor share. The figure shows as the sum of the growth rates of its of trend labor productivity estimated that measured either way, trend nominal three components. For the aggregate by the Chicago Fed staff along with wage growth had essentially the same economy, this implies that (aggregate) earlier forecasts from the Congressional pattern until about 2001. From then nominal wage growth can be expressed on, accounting for labor share became as the sum of the growth in the aggregate Budget Office (CBO). We use the Survey of Professional Forecasters’ (SPF)2 ten-year important as it led to a notably lower labor share, labor productivity growth, and the inflation rate (i.e., price growth). ahead forecast to measure trend inflation. estimate of trend nominal wage growth. Our measure of trend nominal wage Figure 2 shows why this is the case. It Similarly, the trend of nominal wage growth is simply the sum of the trend plots actual and trend labor share. The growth can be expressed as the sum of growth rates of its three components. the trend growth in labor share, trend labor productivity growth, and the 3. Components of actual and trend nominal wage growth trend inflation rate. 0.58 We are interested in the nominal wage growth gap in order to understand which factors are contributing to the currently low rate of wage growth. The wage growth gap is the difference between the nominal wage growth observed in the data and trend wage growth. It can be represented as the sum of the gaps for its component parts, i.e., differences between observed and trend values for labor share growth, labor productivity growth, and inflation. If one of the component CBO/ Chicago Fed Growth Real trend labor Trend Growth in trend output productivity Core PCE PCE in labor labor Period per hour growth inflation inflation share share 1981:Q3– 1990:Q3 1.65 1.68 4.43 5.24 –0.12 –0.01 1990:Q3– 2001:Q1 2.15 2.27 2.21 2.79 0.15 –0.15 2001:Q1– 2007:Q4 2.61 2.47 1.90 2.09 –0.83 –0.73 2007:Q4– 2010:Q4 2.37 1.26 1.55 2.15 –1.42 –0.99 2010:Q4– 2015:Q1 0.53 1.36 1.55 2.08 –0.06 –0.78 Sources: CBO potential labor productivity growth is the ratio of potential GDP to potential hours worked in the nonfarm business sector from the Congressional Budget Office. Trend PCE (personal consumption expenditures) inflation is the ten-year expected PCE price inflation from the Survey of Professional Forecasters. Growth in real output per hour is nonfarm business real output per hour of all persons from the U.S. Bureau of Labor Statistics. 4. Decomposition of nominal wage growth gap, ignoring labor share 5. Decomposition of nominal wage growth gap, accounting for labor share y/y percent change y/y percent change 6.0 6.0 4.0 4.0 2.0 2.0 0.0 0.0 –2.0 –2.0 –4.0 –4.0 –6.0 2000 ’02 ’04 Residual gap Inflation gap ’06 ’08 ’10 ’12 ’14 Labor productivity gap Nominal wage growth gap Sources: Authors’ calculations using nonfarm business compensation and output per hour from the U.S. Bureau of Labor Statistics, core PCE (personal consumption expenditures) inflation from the U.S. Bureau of Economic Analysis, and ten-year expected inflation from the Survey of Professional Forecasters. figure shows the clear and steady decline in labor share that began around 2001. As a result, we see a widening difference between the trend nominal wage growth that accounts for the decline in labor share and the sum of trend labor productivity plus trend inflation in figure 1. Thus, while nominal wage growth is relatively low by historical standards, trend wage growth is low as well, particularly once we account for the decline in labor share. Figure 3 presents averages over various periods for the components of nominal and trend wage growth—labor productivity growth, core PCE inflation, and labor share growth. Trend labor productivity growth declined considerably from 2007:Q4 onward, while trend inflation remained roughly constant at 2.1%. From 2007:Q4 to 2010:Q4, trend growth in labor share was –0.99%; and from 2010:Q4 through 2015:Q1, it was –0.78%. Trend growth in labor share was essentially negligible before 2001, averaging –0.01% from 1981:Q3 through 1990:Q3 and –0.15% from 1990:Q3 through 2001:Q1. Decomposing nominal wage growth As we discussed earlier, one can decompose the gap between actual and trend nominal wage growth into the gaps of its component parts. Figure 4 plots this decomposition from 2000:Q1 through –6.0 2000 ’02 ’04 ’06 ’08 Residual gap Labor productivity gap Nominal wage growth gap ’10 ’12 ’14 Labor share gap Inflation gap Sources: Authors’ calculations using nonfarm business compensation and output per hour from the U.S. Bureau of Labor Statistics, core PCE (personal consumption expenditures) inflation from the U.S. Bureau of Economic Analysis, ten-year expected inflation from the Survey of Professional Forecasters, and labor share estimates from the Board of Governors of the Federal Reserve System. 2015:Q1 for the case where we ignore changes in labor share. The quarterly nominal wage growth gap is represented by the line, while the bars represent the contribution of component gaps. A bar greater than zero increases the wage growth gap, and a bar less than zero decreases the wage growth gap. Over much of this period, the wage growth gap is negative, meaning that trend nominal wage growth (assuming no change in labor share) exceeds observed nominal wage growth. The gap is most negative during the economic downturns (2001–03 and 2008–12), both of which experienced weak labor markets well after the official end of each recession. From 2010:Q4 through 2015:Q1, the nominal wage growth gap averaged –1.34 percentage points, with roughly 60% due to below-trend growth in labor productivity and the remainder due to below-trend growth in inflation. The residual, which includes changes in labor share in this decomposition, contributes only 0.09 percentage points to the reduction in the wage growth gap over this period. In 2015:Q1, the wage growth gap was –1.53%, with roughly equal shares attributable to the labor productivity gap and the inflation gap. Over the whole period, the residual averages a contribution of –0.56 percentage points to the wage growth gap, but this masks the fact that the residual has large negative contributions during the recession periods and modestly positive contributions during the 2004–07 expansion period. In figure 5, we present the same decomposition, this time explicitly accounting for a labor share gap. When we account for changes in labor share, the nominal wage growth gap averages Charles L. Evans, President; Daniel G. Sullivan, Executive Vice President and Director of Research; David Marshall, Senior Vice President and Associate Director of Research; Spencer Krane, Senior Vice President and Senior Research Advisor; Daniel Aaronson, Vice President, microeconomic policy research; Jonas D. M. Fisher, Vice President, macroeconomic policy research; Robert Cox, Vice President, markets team; Anna L. Paulson, Vice President, finance team; William A. Testa, Vice President, regional programs, and Economics Editor; Helen Koshy and Han Y. Choi, Editors; Julia Baker, Production Editor; Sheila A. Mangler, Editorial Assistant. Chicago Fed Letter is published by the Economic Research Department of the Federal Reserve Bank of Chicago. The views expressed are the authors’ and do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System. © 2015 Federal Reserve Bank of Chicago Chicago Fed Letter articles may be reproduced in whole or in part, provided the articles are not reproduced or distributed for commercial gain and provided the source is appropriately credited. Prior written permission must be obtained for any other reproduction, distribution, republication, or creation of derivative works of Chicago Fed Letter articles. To request permission, please contact Helen Koshy, senior editor, at 312-322-5830 or email Helen.Koshy@chi.frb.org. Chicago Fed Letter and other Bank publications are available at https://www.chicagofed.org. ISSN 0895-0164 only −0.56 percentage points between 2010:Q4 and 2015:Q1, a reduction of 58% from the gap estimated using the previous decomposition. Furthermore, the gap is smaller (in absolute value) than the sum of the average inflation gap of −0.53 percentage points and the average labor productivity gap of −0.83 percentage points. The difference is almost entirely accounted for by the positive average labor share gap of 0.72 percentage points. Trend labor share continued to fall during this period, as figure 2 shows, but actual labor share fell by less. This led to a smaller wage growth gap than was predicted by inflation and labor productivity alone. The contribution is consistent with the behavior of the labor share gap since 2000—it contributes positively to the wage growth gap during expansions and negatively to the gap during downturns. Conclusion We find that accounting for changes in the labor share of output, both observed changes and changes in its trend, is important for measuring whether, and by how much, nominal wage growth is below its trend value. We find that wages have been growing below their estimated trend over the 2010–15 period, but not nearly as much as ignoring labor share would suggest. Accounting for abovetrend growth in labor share over this period suggests that this gap averaged –0.56 percentage points, while ignoring the declining labor share trend suggests that the gap was –1.34 percentage points. The smaller gap implies that there is considerably more nominal wage pressure, and consequently less slack, in the labor market than an analysis that ignores labor share would suggest. 1 In this Chicago Fed Letter, “trend” refers to the value a variable would have in the absence of the business cycle. 2 See https://www.philadelphiafed.org/ research-and-data/real-time-center/ survey-of-professional-forecasters/. 3 More precisely, trend nominal wage growth is measured as the sum of its component trends, but actual nominal wage growth is instead measured directly from the data. As a result, part of the nominal wage growth gap will be due to measurement differences across the data sets used to estimate trend wage growth. The residual refers to this component.
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